Law Of Comparative Advantage

The debates about Brexit and President Trump’s trade machinations have demonstrated the blindness of otherwise intelligent people to the Law of Comparative Advantage. Let me attempt a contemporary definition:

“The Law of Comparative Advantage states that an entity maximises its resources by producing that which gives the best return, while delegating production of all other products and services to other entities more cost-effective in their production”

This is the justification behind the principle of the division of labour. But it is amazing how people ignore it when it comes to cross-border trade, particularly the Remainers in the Brexit debate, and Donald Trump with his trade policies.

The law has a long history and was usually associated with David Ricardo, who applied the principle to explain trade between two countries. It might have been better to have explained it in more basic terms, but we must remember that in 1817, when Ricardo published his Principles of Political Economy, in which he devoted a few paragraphs to it, that trade was a political issue.

International trade became overtly political when in 1806 Napoleon ordered a blockade of all trade with Britain from Europe, resulting predictably in anti-trade pamphlets, on the lines that British agriculture was what mattered, and commerce was less important. James Mill, in his Commerce Defended in 1808 attacked these trade fallacies, eleven years before Ricardo’s Principles was published.

Today, we have the benefit of a better understanding of free trade, so we can explain the Law of Comparative Advantage in more relevant terms. There are two issues to address, economic and political. The economic issue is simply explained.

We can do this in two stages, first absolute and then comparative. Humans specialise and in all cooperative economies are not skilled in the production of most of the goods and services they require. Therefore, it makes sense to maximise productive output by doing the few things we are individually good at and acquire the supplementary things we require from others, who are better than us at producing them. It would be unproductive for a farmer to make his own cooker or washing machine. Likewise, it would also be nonsensical, and impractical for factory workers to go farming. Thus, the farmer has an absolute advantage in his specialisation over the factory workers, and they have an absolute advantage over the farmer in their production.

But it goes even further. Let us assume the farmer grows wheat. Let us further assume other farmers grow wheat of the same or better quality at a lower cost. In that case, the first farmer will consider growing something else, where his profits are likely to be greater. The other farmers have a comparative advantage over the first farmer, and if the first farmer finds a more profitable niche than producing wheat, he will gain a comparative advantage over other farmers already specialising in his new production.

In other words, an absolute advantage is the simple deployment of skills through the division of labour. The comparative advantage is the deployment of skills to maximise production. Comparative advantage is hugely important, because by recognising it, we deploy capital more efficiently, capital being money, equipment, labour and our own skills. In the process we maximise value and economic progress for all.

An aprioristic law that is true in economics, such as that of comparative advantage, knows no national boundaries. If Chinese businesses can produce steel more cheaply than businesses in the US, US steel businesses can benefit from the comparative advantage of buying in cheap Chinese steel. And if Chinese producers have so much steel stockpiled that they decide to offer it below cost, US manufacturers of products buying that steel get to benefit.

Obviously, a US steel producer will dislike Chinese steel being cheaper than the cost of production in the US. But by not admitting to the comparative advantage, the US steel company is merely deploying productive capital less efficiently than it otherwise might. The management, like our wheat farmer above, should consider changing its business focus, perhaps to producing speciality steels, buying in Chinese steel as a feedstock for more profitable lines.

This does happen. But because the cheapest steel comes from abroad, lobbyists for the steel industry see an advantage in playing on nationalism, pointing out that China could dump steel to bankrupt US steel producers before raising prices again. But if a US producer cuts prices to dispose of surplus stock, no one bats an eyelid.  A foreign entity doing so is regarded as a different matter.

This is why politics almost always takes precedence over the realities of comparative advantage when it comes to international trade, and why politicians are blind to the economic case and opt for tariffs instead. Tariffs do what they are designed to do, and that is they excuse domestic producers from having to deploy their capital to the maximum advantage in a global context. And over time, we see the consequences. Domestic corporations become progressively less efficient and less competitive in international trade.

Fortunately, the high tariffs of yesteryear are limited to countries and economic blocs not trading under WTO rules, such as the members of the EU. The EU imposes many higher tariffs to protect a range of businesses, forcing consumers to pay higher prices than they otherwise would. Where they do trade under WTO rules, their products improve to become competitive.

But despite this protectionism which Remainers argue is an advantage to British business, British trade is declining with the EU relative to the rest of the world. This shows that taken as a whole, British industry is exercising its comparative advantages in global trade, notwithstanding the supposed benefit of free trade within the single market. Therefore, any relief in this direction through free trade agreements, or preferably no tariffs at all, can be expected to see a far healthier British economy. And crucially, the economies of Britain’s trading partners would also benefit from the more efficient deployment of capital in their domestic economies.

This is the direction of travel for much of British business anyway, with industry becoming resigned to Brexit, and just getting on with maximising capital resources. Last Tuesday, City AM reported that 98% of London’s largest law firms thought Brexit will have no significant impact on their employment levels, and 95% thought it would have no impact on profitability. This is important, because law firms are central to London’s financial business, and if they see no net loss of business to other European centres from Brexit, then neither will the rest of the City.

The role of politics

Therefore, the denial of the importance of comparative advantage in international trade is entirely down to politics, which was the nub of Ricardo’s and Mills’s argument. Today as usual, politics looks only at one side of an argument, such as the immediate interests of a manufacturer seeking protection from foreign competition. It ignores all else, particularly the loss of benefit to consumers and the long-run consequences of less efficient deployment of capital by domestic corporations.

Both these can be described as being the unseen benefits of free trade. Instead, it is easier to fall for the proposition that this or that industry needs protection. For this reason, the UK Treasury, the Bank of England, and big business as well, all expected an immediate disruption to their economic and business prospects from the disorder of Brexit, and to this day are still emotionally against it.

For those who understand the law of comparative advantage, the Remainers argument is simply protectionist. By not understanding it, irrelevant and spurious arguments such as the gravity model of trade are touted. The gravity model, which was first put forward in the 1950s, basically states that trade opportunities between two countries are inversely proportional to the distance between them. Therefore, the EU should be the preferred trading partner for Britain.

The gravity model even flies in the face of contemporary experience, with UK’s trade with the EU declining as a proportion of the total, and trade with jurisdictions further afield increasing, despite the additional hurdle of WTO tariffs. Furthermore, China is speeding up the transportation of goods across Asia into Europe, halving the time taken. But this doesn’t stop mainstream economists and others against Brexit placing their outdated gravity models above comparative advantage.

If there is a failure in the Brexit camp, it has been to not educate people in the Law of Comparative Advantage. Perhaps ministers and senior civil servants themselves don’t fully understand the dynamics of trade, a fault seen on both sides of the Atlantic.

It is ironic that Donald Trump, a non-politician who promised to bring business sense to government turns out to be the most political animal of all with respect to foreign trade. Presumably, as a businessman, he understands there is no point in investing resources in the production of something others do better. Yet as a politician, this knowledge is driven out of him by patriotism, jingoism, perhaps even xenophobia.

The result, in both America and possibly Britain post-Brexit (if the politicians end up getting Brexit horribly wrong), is likely to be the incentive for the private sector to maximise the use of productive capital will be undermined. Nearly all production of goods and services is initially targeted at domestic markets, and protection from foreign competition allows manufacturers to resist the changes that ultimately keep them internationally competitive.

These were the trade conditions in Britain in the 1970s, which led to Britain being described as the sick man of Europe and diagnosed as suffering from the British disease. A return to those conditions can be easily avoided, if the reasons for them are properly explained to the ordinary person. And as this short article hopefully demonstrates, the Law of Comparative Advantage is relatively easy to explain.

We should renew our efforts to communicate it to our leaders as well, who repeatedly show less understanding of economic reality than many of those they represent.

Alasdair Macleod

HEAD OF RESEARCH• GOLDMONEY

 Twitter: @MacleodFinance

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